Using Options to Hedge Short-Term Risk
October 21, 2021
While derivatives such as options are usually strategies or tools that are more relevant for active traders who aggressively move in and out of positions, long-term investors can also take advantage of options to hedge near-term risks.
Long-term investors might not be too concerned over the short-term dip in the market amid uncertainties such as the timing of the US Federal Reserve’s tapering and potential interest rate hike, or even the rising concerns over China’s Evergrande debt problem.
But these same investors can reduce the volatility of the performance of their portfolio by taking advantage of options.
How to utilise options
A good strategy for this is to sell or short call option on a security that a long-term investor has.
For example, Tim believes that the long-term growth prospects for Microsoft Corporation (NASDAQ: MSFT) remains intact despite concerns over the impact of the tightening of the monetary policy on growth and technology-related stocks.
We also know that the recent share price movement for Microsoft has been rather volatile as the risk of prolonged inflation emerges.
While it would be easy to focus on the fundamentals, management and key growth prospects of the company, investors could take a more proactive measure by entering into a short call option on Microsoft for a short period of time. This helps to reduce the volatility of the return.
Supposed you own 1,000 shares of Microsoft at US$295 per share and simultaneously write or short call options (one contract for every 100 shares) with a strike price of US$310 per share expiring in one month, at a cost of US$0.25 per share, or $25 per contract, and $250 total for the 10 contracts.
The $0.25 premium reduces the cost basis on the shares to US$294.75, so any drop in the underlying security down to this point will be offset by the premium received from the option position, thus offering limited downside protection.
If Microsoft’s share price rises above US$310 before expiration, the short call option will be exercised by the buyers of the options (or called away), meaning you will have to deliver the stock at the option’s strike price at US$310.
In this case, you will make a profit of US$15.25 per share (US$310-US$294.75 cost basis). You would have missed out on the further gain if Microsoft’s share price continues to climb significantly higher than the US$310 level.
However, in the event that the share prices were to fall in the near-term, a covered call strategy implemented here will provide limited downside protection for your long-term investment pick.
If Microsoft’s shares remain in a trading range below US$310 and do not fall too low below US$295 level, you will keep the premium free and clear, and could continue with the short call option against the share if desired.
The downside to this is, of course, that long-term investors might miss the bull run in the event that the share price surges.
One tactical play on this front is to write or short call options for some of the holdings they have in underlying shares instead of the entire holdings of the shares.
So, in this case, instead of short call against Microsoft for 10 contracts, you can opt for just one contract.
The bottom line is that the covered call strategy helps long-term investors to hedge some of the near-term risks, especially when market volatility is high and the outlook full of uncertainty.
Billy is passionate about the capital market and believes in investing for the long haul. Prior to this, he was an economist at RHB Investment Bank, covering Thailand and Philippines market. He also worked as a financial journalist at The Edge Malaysia and has experience working with an asset management firm. Aside from the capital market, Billy loves a good conversation over a cup of coffee, is a fitness enthusiast and a tech geek.